Private equity's three lessons for agency theory

European Business Organization Law Review

Volumn 9, Issue 4, 2008, Pages 509-533

  Bratton, William W ^a  

^a GEORGETOWN UNIVERSITY LAW CENTER   (United States)

Author keywords

Agency costs; Hostility; Institutional investors; Leverage; Mergers; Private equity; Takeovers

Indexed keywords

EID: 77649100050     PISSN: 15667529     EISSN: 17416205     Source Type: Journal    
DOI: 10.1017/S1566752908005090     Document Type: Article

References (101)

1. See M.C. Jensen, 'Eclipse of the Public Corporation', Harvard Business Review (Sept.-Oct. 1989), revised 1997, available at: http://ssrn.com/ abstract=146149;
2. R.J. Gilson and C.K. Whitehead, 'Deconstructing Equity: Public Ownership, Agency Costs, and Complete Capital Markets', 108 Columbia Law Review (2008) p. 231, at pp. 233-368.
3. See A. Choudhury, 'Cerebus, Carlyle Profit from Sales in LBO Drought', Bloomberg (13 Aug. 2008), available at: http://www.bloomberg.com/apps/ news?pid=20670001&refer=home& sid=aJGREa0y4Qvg.
4. Blackstone Group L.P., Form S-1, SEC File 333-141504, filed 22 March 2007.
5. Ibid..
6. Ibid..
7. M.C. Jensen, 'Agency Costs, Free Cash Flow, Corporate Finance, and Takeovers', 76 American Economic Review (1986) p. 323.
8. Ibid., at pp. 323-24.
9. M.C. Jensen, supra n. 1.
10. See, e.g., Federal Deposit Insurance Act, 12 U.S.C. § 1831e(d) (providing that thrift institutions may only invest in investment grade debt securities); 1991 Conn. Acts 91-262 §§ 3(c), 4(c) (limiting junk bonds to 10% of insurance company portfolios).
11. See B. Holmstrom and S.N. Kaplan, 'Corporate Governance and Merger Activity in the United States: Making Sense of the 1980s and 1990s', 15 Journal of Economic Perspectives (2001) p. 121, at p. 122.
12. Ibid..
13. Ibid..
14. See E. Nikoskelainen and M. Wright, 'The Impact of Corporate Governance Mechanisms on Value Increase in Leveraged Buyouts', 13 Journal of Corporate Finance (2007) p. 511, at p. 512 (surveying the empirical studies);
15. G.D. Bruton, J.K. Keels and E.L. Scifres, 'Corporate Restructuring and Performance: An Agency Perspective on the Complete Buyout Cycle', 55 Journal of Business Research (2002) p. 709, at p. 711 (same).
16. See Gilson and Whitehead, supra n. 1, at pp. 251-62.
17. See R.W. Masulis and R.S. Thomas, Does Private Equity Create Wealth?, Working Paper (2008), at pp. 25-26, 28-34, available at: http://ssrn.com/abstract=1215188 (suggesting that the proliferation of derivative devices opens up new means of spreading risk and so makes public ownership less important, and that private ownership at the same time facilitates better risk management of complex derivative positions).
18. B.R. Cheffins and J. Armour, The Eclipse of Private Equity, Law Working Paper No. 082 (European Corporate Governance Institute, 2007), available at: http://ssrn.com/abstract=982114.
19. K.J. Martin and J.J. McConnell, 'Corporate Performance, Corporate Takeovers, and Management Turnover', 46 Journal of Finance (1991) p. 671.
20. R.A. Brealy and S.C. Myers, Principles of Corporate Finance, 5th edn. (Boston, Irwin McGraw-Hill 1996) p. 823.
21. Holmstrom and Kaplan, supra n. 10, at pp. 127-29.
22. J. Franks and C. Mayer, 'Hostile Takeovers and the Correction of Managerial Failure', 40 Journal of Financial Economics (1996) p. 163, at p. 166.
23. R. Sinha, 'The Role of Hostile Takeovers in Corporate Governance', 14 Applied Financial Economics (2004) p. 1291.
24. M.C. Jensen, 'Takeovers: Their Causes and Consequences', 2 Journal of Economic Perspectives (1988) p. 21.
25. G.W. Schwert, 'Hostility in Takeovers: In the Eyes of the Beholder?', 55 Journal of Finance (2000) p. 2599.
26. Schwert, supra n. 23.
27. See, e.g., A. Brav, et al., 'Hedge Fund Activism, Corporate Governance, and Firm Performance', 63 Journal of Finance (2008) p. 1729, at pp. 1739-45.
28. W.W. Bratton, 'Hedge Funds and Governance Targets', 95 Georgetown Law Journal (2007) p. 1375, at pp. 422-27.
29. Ibid., at pp. 1405-09.
30. H. Servaes, 'Do Takeover Targets Overinvest?', 7 Review of Financial Studies (1994) p. 253.
31. Ibid., at p. 254.
32. Ibid..
33. See also B. Jovanovic and P.L. Rousseau, The Q-Theory of Mergers, Working Paper No. 8740 (National Bureau of Economic Research, 2002), at p. 1 (finding that the free cash flow account explains only a small number of mergers and asserting that a typical firm may waste cash on mergers but not on internal investment);
34. G.T. Garvey and G.R. Hanka, The Management of Corporate Capital Structure: Theory and Evidence (January 1997), at p. 520, available at: http://ssrn.com/abstract=1501 (studying the effect of anti-takeover provisions and finding that protection does not impact firm size or profitability).
35. See D. Cumming, D.S. Siegel and M. Wright, 'Private Equity, Leveraged Buyouts, and Governance', 13 Journal of Corporate Finance (2007) p. 439, at pp. 441-42 (showing that targets are selected based on stock market valuation (undervalued companies being preferred) and the projected tax savings stemming from leveraged capital structure). This does not go to say that today's managers always return free cash flow to their shareholders. They often hoard cash, but they put it into short-term liquid investments rather than safe businesses. Bratton, supra n. 26, at pp. 1415-18. Such a cash account could indeed motivate a buyout offer, but as source of an immediate post-closing dividend rather than as a source of a disciplinary improvement.
36. See Cumming, et al., supra n. 31, at pp. 444-50 (summarising the literature and discussing the empirical difficulties);
37. G.D. Bruton, et al., 'Corporate Restructuring and Performance: An Agency Perspective on the Complete Buyout Cycle', 55 Journal of Business Research (2002) p. 709, at pp. 716-19 (showing performance improvements during the buyout period in a sample of buyout firms that later conducted reverse LBOs).
38. See Cumming, et al., supra n. 31, at p. 441 (confirming that buyout firms look for undervalued targets).
39. See Blackstone Group L.P., supra n. 3, at p. 115.
40. For an empirical study of buyouts conducted in the 1990s that confirms the salience of financial and tax over performance motivations, see S. Guo, et al., Do Buyouts (Still) Create Value?, Working Paper (2008), at pp. 2-4, available at: http://ssrn.com/abstract=1108808.
41. For empirical confirmation of this point, see U. Axelson, et al., Leverage and Pricing in Buyouts: An Empirical Analysis, Working Paper (2008), at pp. 4-5, available at: http://ssrn.com/abstract=1027127 (showing that levels of debt in LBOs are unrelated to firm characteristics but highly sensitive to prevailing interest rates in the leveraged loan market). At the same time, merger premiums in recent years generally have been lower than in the 1980s. Where the earlier rule of thumb was 30 to 50 percent premium, in recent years 20 percent deals have been common.
42. Blackstone Group, L. P., supra n 3.
43. See Guo, et al., supra. n. 35, at pp. 4-6 (showing that 1990s buyouts entailed lower leverage and lower up-front premiums).
44. E. Thornton, 'Done Deals in Distress: Debt Issued for Recent Buyouts Is Fast Losing Value', Business Week, 11 February 2008, at p. 30.
45. For a critical analysis of the documentation at issue in these failed transactions, see S.M. Davidoff, The Failure of Private Equity, Working Paper (2008), available at: http://ssrn.com/abstract=1148178.
46. Thornton, supra n. 39, at p. 31.
47. L. Rappaport and P. Lattman, 'Anyone for Some Used Corporate Debt? Why Leveraged Loans That Financed Buyouts Are Causing Bottleneck', Wall Street Journal, 6 February 2008, at p. C1.
48. Thornton, supra n. 39, at pp. 30-31.
49. C. Mollenkamp, et al., 'Leveraged Loans Inflict More Pain on Banks Globally', Wall Street Journal, 19 February 2009, at p. C2.
50. Thornton, supra n. 39, at p. 30.
51. See supra nn. 8-9 and accompanying text.
52. It is, however, noted that Michael Jensen warns of unspecified new regulation in a posted PowerPoint slide show, M.C. Jensen, The Economic Case for Private Equity (and Some Concerns) - PDF of Key Note Slide, available at: http://ssrn.com/abstract=963530.
53. F. Modigliani and M. Miller, 'The Cost of Capital, Corporation Finance, and the Theory of Investment', 48 American Economic Review (1958) p. 261.
54. The suboptimal reinvestment of free cash flow story told in the 1980s affected such a tie. See supra text accompanying n. 7.
55. S.N. Kaplan and A. Schoar, 'Private Equity Performance: Returns, Persistence, and Capital Flows', 6 Journal of Finance (2005) p. 1791, at p. 1794.
56. To be included in the sample, the fund must have distributed no returns for at least six quarters. Kaplan and Schoar assume that any undistributed residuals values on a fund's books are worth their book amount. Ibid., at pp. 1794, 1798. It is noted that this assumption favours the funds.
57. Ibid., at p. 1797.
58. Ibid., at pp. 1801-02.
59. L. Phalippou and O. Gottschalg, Performance of Private Equity Funds, EFA 2005 Moscow Meetings, available at: http://ssrn.com/abstract= 473221. See also O. Gottschalg, Private Equity and Leveraged Buy-outs, Study for the European Parliament Economic and Scientific Policy Department, IP/A/Econ//IC/2007-25, at pp. 12-15, available at: http://www.privateequity council.org/studies-research (showing an average 3 percent above market per annum performance gross of fees, and a negative 3 percent below market per annum performance net of fees).
60. Phalippou and Gottschalg, supra n. 53, at p. 11.
61. Kaplan and Schoar, supra n. 49, at p. 1798 (Table II).
62. Phalippou and Gottschalg, supra n. 53, at pp. 19-20. C. Diller and C. Kaserer, What Drives Private Equity Returns? - Fund Inflows, Skilled GPs, and/or Risk?, CEFS Working Paper No. 2004-2 (2004), available at: http://ssrn.com/abstract=590124, calculates PME for 200 European buyout funds to get similar results - the average is 0.90 and the median 0.89.
63. For a set of contrary results, see A. Ljungqvist and M. Richardson, The Cash Flow, Return and Risk Characteristics of Private Equity, NYU Finance Working Paper No. 03-001 (2003), available at: http://ssrn.com/abstract= 369600. This gets an IRR for buyouts of 21.83 which compares favourably to the S&P 500's 14.1. On the other hand, the sample dates from the early 1980s, the period that shows the most favourable results in Kaplan and Schoar's larger sample.
64. For a set of mixed results, see M.M. Ick, Performance Measurement and Appraisal of Private Equity Investments Relative to Public Equity Markets (May 2005), available at: http://ssrn.com/abstract=871931.
65. Phalippou and Gottschalg, supra n. 53, at p. 4.
66. J.X. Cao and J. Lerner, The Performance of Reverse Leveraged Buyouts (15 October 2006), at p. 4, available at: http://ssrn.com/abstract= 937801.
67. See G.D. Bruton, J.K. Keels and E.L. Scifres, 'Corporate Restructuring and Performance: An Agency Perspective on the Complete Buyout Cycle', 55 Journal of Business Research (2002) p. 709, at p. 711.
68. Cao and Lerner, supra n. 58, shows performance superior to peers on both market and accounting bases for a sample of 526 RLBOs during the period 1981 to 2003.
69. See also C.J. Muscarella and M.R. Vetsuypens, 'Efficiency and Organizational Structure: A Study of Reverse LBOs', 45 Journal of Finance (1990) p. 1389 (studying 72 RLBOs in the period 1983-87 and showing substantial increases in profitability in comparison to the firm's pre-LBO results);
70. F. Degeorge and R. Zeckhauser, 'The Reverse LBO Decision and Firm Performance: Theory and Evidence', 48 Journal of Finance (1993) p. 1323 (studying 62 RLBOs in the period 1983-87 and showing that their accounting performance exceeds peer group performance prior to going public and then deteriorates after the public offering but no evidence of post-RLBO underperformance in the stock market);
71. S. Mian and J. Rosenfeld, 'Takeover Activity and the Long-run Performance of Reverse Leverage Buyouts', 22 Financial Management (1993) p. 46 (showing slight outperformance of stock market peers with a 1980s sample);
72. R.W. Holthausen and D.F. Larcker, 'The Financial Performance of Reverse Leverage Buyouts', 42 Journal of Financial Economics (1996) p. 293 (studying 90 RLBOs in the period 1983-88 and showing no evidence of poor performance based on accounting or stock price).
73. S.N. Kaplan, 'The Staying Power of Leveraged Buyouts', 29 Journal of Financial Economics (1991) p. 297.
74. Cao and Lerner, supra n. 58, at p. 7.
75. Phalippou and Gottschalg, supra n. 53, at Table 3.
76. Ibid..
77. See Nikoskelainen and Wright, supra n. 13, at p. 513.
78. See Cumming, et al., supra n. 31.
79. A. Metrick and A. Yasuda, The Economics of Private Equity (9 September 2007), at p. 3, available at: http://ssrn.com/abstract=996334. Note that the institutions offered the limited partnership interest in the new funds accordingly must make their appraisals based only on the previous fund's interim results.
80. Ibid..
81. Kaplan and Schoar, supra n. 49, at pp. 1791-93, 1816-19.
82. P. Gompers and J. Lerner, 'Money Chasing Deals? The Impact of Fund Inflows on Private Equity Valuations', 55 Journal of. Financial Economics (2000) p. 281 (analysing venture capital only).
83. Ibid.;
84. Ljungqvist and Richardson, supra n. 56, at p. 16.
85. For a confirming industry study, see Boston Consulting Group and IESE Business School, The Advantage of Persistence: How the Best Private Equity Firms 'Beat the Fade' (February 2008), available at: http://www.bcg.com/ impact-expertise/publications/publication-list.jsp?pubID=2574.
86. Kaplan and Schoar, supra n. 49, at pp. 1791-93.
87. For a critical follow-on finding, see J. Driessen, T. Lin and L. Phalippou, A New Method to Estimate Risk and Return of Non-Traded Assets from Aggregate Cash Flows: The Case of Private Equity Funds (Aug. 2007), at p. 22, available at: http://ssrn.com/abstract=965917, which accounts for the higher returns at experienced funds in terms of higher risk.
88. L. Phalippou, Caveats When Venturing into the Buyout World (July 2007), at p. 3, available at: http://ssrn.com/abstract=999910.
89. Ibid., at pp. 7, 13-14.
90. Phalippou, supra n. 73, at p. 4.
91. Cao and Lerner, supra n. 58, at p. 4.
92. R.C. Green and J.B. Berk, Mutual Fund Flows and Performance in Rational Markets, Working Paper No. W9275 (National Bureau of Economic Research, 2004), available at: http://ssrn.com/abstract=338881.
93. Metrick and Yasuda, supra n. 67, at pp. 8-9.
94. Ibid..
95. Ibid., at p. 9.
96. Ibid., at pp. 9-12.
97. Ibid., at p. 16.
98. Ibid., at pp. 16-18.
99. Ibid., at pp. 31-34.
100. See also Phalippou and Gottschalg, supra n. 53, at p. 17 (showing that compensation comes from mainly large management fees and not the carry).
101. Private equity firms contribute only a small fraction of the limited partnership equity, typically 1 percent. See G.W. Fenn, et al., The Economics of the Private Equity Market, Federal Reserve Report (1995), at p. 28, available at: http://www.federalreserve.gov/pubs/staffstudies/ 1990-99/ss168.pdf.